Why the Saudis Will Regret Their Big Oil Bet

If you had any doubt about the ongoing volatility in oil prices, the past several trading sessions are a clear reminder the dust hasn’t settled yet.

After jumping over 19% in four sessions, West Texas Intermediate (WTI), the benchmark in New York, fell almost 8.3% yesterday, closing under $50 a barrel. Meanwhile, Brent dropped 4.4% to $54.47 a barrel after posting a similar 17.6% gain.

Of course, Brent ordinarily trades a bit higher than WTI, reflecting the “spread” between the two that has favored the London benchmark in all but a few trading sessions since mid-August 2010.

There are two reasons for this.

First, Brent is used as the standard price for more international oil sales than WTI, making it the more commonly used yardstick.

Second, the London market is more immediately influenced by global events. Being more sensitive to geopolitical changes, Brent is more likely to spike in response to a crisis, so it typically demands a higher price.
The primary factor in all of this has been the supply. Unlike the situation in earlier price declines, demand is holding up quite well and even beginning to inch up.

Supply, on other hand, is quite another matter….

Oil Prices: How the Supply Dynamics Have Changed

Over time, there have been two major changes on the supply front that have changed the dynamics of the “traditional” OPEC-driven market.

Russia took the lead in global crude exports, and massive unconventional (shale and tight) oil reserves completely changed the production picture in the U.S. So in order to protect their market share, the Saudis decided to fight back.

And in stark contrast to what they did previously in similar situations, the Saudis pressured OPEC not to cut production, creating an even bigger glut. Instead, Riyadh decided they would tolerate lower oil prices, while the market readjusted more in their favor.

That marked a decided break from their normal operations.

In the past, OPEC has adjusted its spigots to redress either a jump in non-OPEC supply (translating into an OPEC cut in exports) or falling non-OPEC supply (resulting in an increase in OPEC sales).

In doing so, the cartel has been able to hold sway over the price of oil. In fact, this is how OPEC usually establishes its monthly policy.

First, they estimate the global demand. Then, they estimate what is likely to be met from non- OPEC sources. Finally, after subtracting the non-OPEC supply from the projected demand, they arrive at what is referred to as “the call on OPEC.”

This “call” becomes the monthly export target for the organization, and is divided into quotas for each member nation. This is how OPEC has managed to control the international market.

Since it only controls 40% of global production, the cartel doesn’t directly dictate the price. It simply provides the balance on the supply side, heavily influencing the price of oil.

OPEC’s Fading Leverage

But the Saudis have been reading the writing on the wall for some time now.

Today, Russian crude has become a major competitor in Asia. Moscow has completed the East Siberia Pacific Ocean (ESPO) export pipeline, and now plans to send a better grade of crude at a lower price than the Saudis can deliver.

That’s crucial, since Asia will be the key battleground in energy for the next 20 years. And for years now the Saudis have profited off the “Asian premium” they created simply by charging Asian customers more than their Western counterparts.

However, the Achilles heel for Russian exports has always been the price, since the national budget essentially depends on sales of $80-$85 a barrel (against which Russian exports must be sold at discount). Oil prices falling to around $50 a barrel has decimated Moscow’s central planning and caused the value of the ruble to plummet.

As a result, Russian production plans are being scaled back. So score one for the Saudis.

Yet OPEC’s second target is far more decisive to their strategy.

Here’s why.

The advent of unconventional oil in the U.S. has fundamentally changed the energy world. Despite having to import almost 70% of its daily crude needs only a few years ago, the American market is now looking to become energy independent in as little as 10 years.

By 2025, the U.S. will still require about 30% of its oil from imports, but all of that could easily be transported from Canada (even without the Keystone XL pipeline). In fact, domestic U.S. production is reaching levels never seen before, surpassing 9 million barrels a day – within a million barrels of Saudi production.

This is the real challenge to the Saudis, even more so if current prohibitions on U.S. oil exports are lifted.

What’s more, with 86% of the recoverable unconventional supply located outside North America, the battle with American shale is a dry run for the problems OPEC is about to face globally. That’s what’s really driving the Saudis.

In what amounts to an oil market version of a game of chicken, Saudi policymakers are trying to make U.S. producers blink first.

And it’s starting to work.

Rigs are being brought off line in numbers not seen in over a decade, while plans for more expensive drilling projects are being shelved in favor of less expensive alternatives. This is going to have an impact on the supply side in rather short order.

What is extraordinary is how quickly this has transpired. By this summer, oil prices may be back to a range of $65-$70 a barrel. Meanwhile, some of the more knowledgeable analysts are pegging a price in the $80s by the end of the year.

In a short period of time, the Saudis have succeeded in prompting production cutbacks in both Russia and the U.S. But it has come at a cost Riyadh had not anticipated.

By forcing American producers to pull back, OPEC has lost its position as the balancer in the global oil market. That has now fallen to the U.S.

And by pushing home its point, Saudi Arabia has managed to lose its leverage.

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Kent, you end your blog with the following statement: “By forcing American producers to pull back, OPEC has lost its position as the balancer in the global oil market. That has now fallen to the U.S.” Please could you explain this? What does this mean? What does this new “balance” look like now and going forward?

How have the Saudis lost their leverage? Don’t they still have the lowest production costs on the planet? Haven’t they been successful in moving oil back up from the low? While they are losing revenue by cutting price, they are not losing money as I understand it. According to what I read from several analysts, Canadian oil sands and many fracking projects require $65-$70 oil for break-even.

This is an assumed assessment of what the oil patch looks like worldwide to me: GREED on all sides of the evolving equations!! My diesel mechanic just mentioned to me that there’s a race to see who can save the first trillion $’s in their bank account. My added comment to him was plus the best high paying interest rate they can earn. My mechanic said when does one decide enough is enough? Has Mr. Greed ever been satisfied? Doesn’t Mr. Moderation need to take over the reigns from Mr. Greed is my humble opinion? Billions of people just wish they could pay their monthly bills on time and have a little extra left over each month to spend on themselves without invoking Mr. Greed. Statements on the internet lately have stated that the average family income for 4 people is at around $50,000+ but many 4 person families live earning less than $20,000 a year but the overall picture is drawn in our minds from such statements that the American Middle Class is disappearing. Isn’t it the purchasing power of the US $ (Federal Reserve Notes) which is falling taking down the Middle Class with it or so it appears to me and you dear reader? Nobody today including governments seem capable of living on a finite, limited and balanced budget and so when does Mr. Greed throughout OUR present world get the boot? The US Middle Class should be renamed in my views the US Muddle Class muddling through each crises towards what ends?

One thing that still confuses me is the growing “surplus of oil from US wells” that is filling storage limits. We use more than we can consume, so why isn’t our produced oil being snapped up? The only reason that makes sense is that major oil companies have contracts with foreign sources that they are stuck with. If that is the cause, then how long do those contracts last? If that isn’t the cause, then I am at a loss to explain our surplus. Our WTI oil is cheaper, or is it? Are major oil companies letting US production go into a funk just to make a little more on imports? If that is the case, it seems those methods will backfire on them, keeping oil low. I can’t be the only one confused over this, so it would be nice to have you explain it.
Ed

Thats very true Dr. Kent, but given America’s inability to come up with a national energy policy, how does that ability help ,? Wont the Saudis just keep it flowing to keep U.S rigs and companies shut down ?

If the Saudis allow the price to go back to $ 80, the shale rigs can restart production. If they produce too much oil and export it, the Saudis will crank production again up a notch until the prices go down again. So the shale rigs have to shut down again.

And why all this ? Washington is currently poised to fight Russia over a country thas is ruled by 10 supper corrupt oligarchs and which is about to default shortly on all fronts. So the administration tried to play with the Saudis to make oil prices to go down drastically in the hope, Russia would falt within weeks. Once that happens regime change in Russia woul become the next target.

They did not consider, that by devaluating the rouble exactly to the point where Russia can produce the same amount of roubles from half the revenues from its oil exports. 95 % of ordinary Russians live in roubles. They dont mind if Swiss cheese and French champaign are getting more expensive. So its almost business as usual over there.

The whole incomprehendable manouvre had one devastating effect on the most promising development, this country has seen in decades. It caused severe harm to the fracking industry who has to fire people, shut down rigs and make may go out of business. What an excellent service to the people of the United States. Thank you Washington.

At the very least it seems probable that the myriad of much smaller (as compared to ) US producers are less likely to act in a coordinated, consensus driven direction with respect to setting development and production levels. Given the rather different flow profiles of the typical tight-oil wells (again, vis-a-vis the Saudis) this suggests that “market forces” are likely to have a more immediate and dynamic influence on prices going forward. More volatility?

Low oil prices will put US oil wells at bay. You have to extend this period of low prices so that it would be harder for them to start up again. It will also put the Russians at bay–they cannot last longer at $50/ barrel or less. More than 70% of their income is dependent on this commodity. OPEC oil, as you said, is the cheapest in the world so you alone have this extra margin that you can use as leverage to keep your competitors at bay.

Of course, this will solve your problem only in the medium term. Countries are getting headway in going green and lessening their dependence on fossil fuel. This is an entirely different playing field for you. This early, you will have to create another market for your product. Look at the industries you can tap to use your fossil fuel.

But Kent since when has Saudi Arabia an independent oil policy different than what the US tell them to do. If the United States tells them to raise producton they will raise it. If it tells them to lower it they will lower it.it has nothing to do with shale oil.

@Robert in Vancouver
One: The last I heard, Canada had already gotten a contract with China for all of that output. However, even should this not be the case, we know NONE of the oil that would go through the XL pipeline would stay in the US – period. Americans already know that one, so you can quit lying about it.
Two: I’m very sorry to hear that the people of Canada have refused to put a pipeline through their own country and instead want all of that incredibly dirty tar sands oil to go through the breadbasket of the World. How incredibly Stupid we would have to be to allow it. The people of the US will be fighting the powers that be over this until Big Oil gives up on it. We will never allow the XL to be built anywhere near the aquifer that supplies water to all of the land, people and other creatures that depend on it to LIVE! I know that Canadians are good people, so excuse me, but, I suspect that you represent some kind of Oil Interests.

MareL
The US wants the XL pipeline Obama doesn’t. Canadians have offered to sell our so called “dirty oil” to the US but Obama doesn’t want it. Obama wants renewable energy.
The Canadian government has decided to export it and get an even better price for it on the world markets.
It is difficult to build a pipeline over the mountains to the west coast.
There is opposition to that by environmental groups. The oil can be shipped by rail until a pipeline is built.
Your argument about aquifers is laughable. The US is criss-crossed with pipelines already running over every aquifer.
BTW pipelines are much safer than transporting oil by rail.

So in February, some of the “more knowledgable analysts” were suggesting $80 a barrel oil by end of the year. So with oil at below $40 at Christmastime, perhaps we might deduce that a little knowledge can be dangerous thing.

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